Below, we define the variables that make up the TED spread and explain its utility in the real world, particularly as it pertains to individual investors.
Definition and Example of TED Spread
To thoroughly define and understand the TED spread, it’s important to explain the two key indicators that comprise it. U.S. Treasury bills are often seen as risk-free investments. In other words, they’re free of the risk of non-payment as they’re backed by the United States government. Treasury bills are short-term securities that you can buy and hold for up to one year. The money you invest goes to the government to help fund programs and projects. The London Interbank Offer Rate (LIBOR) represents the interest rate that banks used when loaning money to one another. The U.S. central bank, the Federal Reserve, asked banks to stop using LIBOR as a benchmark as of Dec. 31, 2021. The Secured Overnight Funding Rate (SOFR) may be a rate that ultimately replaces LIBOR. The Federal Reserve publishes the TED spread in a graph. The data is delayed by one week because of the LIBOR data being lagged by one week. In the graph below, you can see how the TED spread has changed over a 20-year period, from January 2001 to December 2021. Below, we dive deeper into the meaning and utility of this data.
How the TED Spread Works
The TED spread functions as an indicator of economic credit risk and financial stability. Generally speaking, a larger TED spread reflects a greater level of credit risk-related anxiety. According to the Federal Reserve Bank of Minneapolis, during “normal times” the TED spread sits around 50 basis points (equal to 0.5% or 50 1/100ths of 1 percentage point). The TED spread typically does not go beyond 100 basis points, however, during times of increased economic uncertainty, it can surge considerably higher. The two best examples of the TED spread reaching historic rates occurred in 2008 and 2020. In a December 2008 report during the financial crisis, the Minneapolis Fed stated that the TED spread had remained around 100 since August 2007, but surged, reaching levels from 200 to around 460, “reflecting substantial anxiety about credit risk.” In March 2020, when the pandemic began, the TED spread approached 150. It rapidly declined in April 2020, leveling out to less than 50 basis points by May 2020. It remained at or below 20 basis points through the end of 2021. During these two times, the TED spread can be seen as a reflection of the financial stress felt by investors and consumers as a result of the financial crisis and the pandemic.
What It Means For Individual Investors
The TED spread may be a key measure of risk and volatility in markets. While it’s generally known that no one can really time the stock market, investors may want to better understand the TED spread and how it has changed over time during periods of economic uncertainty. Looking back, the TED spread could have theoretically indicated market declines in 2008 and 2020. However, remember that the Fed also publishes the TED spread one week after the fact, so you may not have the most up-to-date rate to fuel any investment decisions. Additionally, banks are transitioning away from LIBOR and may use a different rate in the future. Instead of the TED spread, you may want to consider other economic indicators to help drive your strategy. If you’re a long-term investor, there’s a good chance you invest in stocks and funds through a retirement account such as a 401(k) or IRA. You might also invest directly in stocks or funds through a broker, or an online investment account or app. However you invest, putting money into the market at regular intervals helps you buy more shares when prices are low. It also means you’re buying fewer shares when prices are high. This is known as dollar-cost averaging. And paying attention to indicators like the TED spread could help you make smart investment decisions, such as buying more shares when prices are low, and fewer when they’re high. In the end, the TED spread is just one of several factors you can use to gauge market and overall economic sentiment, but it’s important to not solely rely on this information. Keep your personal investment strategy in mind, and work with a financial advisor to ensure you’re making the smartest moves with your portfolio
